Thursday, February 28, 2013

Spain's banking system continues to struggle, with Bankia reporting more losses and tapping the government's bailout vehicle.

The Guardian: - Spain's answer to RBS – Bankia – published the worst results ever seen by a Spanish corporation, racking up 2012 losses of €19.2 bn (£16.6bn) as the nationalised bank drowned in a sea of toxic real estate left over from the country's burst housing bubble.

The figures confirmed the dire fortunes of a bank formed out of a merger of seven of Spain's ailing savings banks in 2010 as the government made a futile attempt to save them from disaster. Client flight during 2012 helped bring a 13% fall in total deposits.

Bankia became the focus of Spain's banking crisis last year after auditors refused to sign off on the accounts presented by company president Rodrigo Rato, a former finance minister from prime minister Mariano Rajoy's People's party (PP) and one-time head of the International Monetary Fund. It is now taking €18bn in bailout funds from the country's Frob bank restructuring fund, which had to borrow the money from the eurozone's bailout fund as part of a €40bn rescue of several struggling banks.

2012 has been particularly difficult for Spanish banks who relied on domestic deposits. Panicked depositors moved cash to Germany or even out of the Eurozone altogether to Switzerland. That forced the banks to tap the ECB's long and short-term lending programs for most of their funding needs.

But there may be some good news on the horizon. Some deposits are returning to Spain - cash flows recently turned positive. The flow data has a great deal of noise due to the effects of recent tax deposits as well as the issuance of commercial paper (pagares). The adjustment for pagares is shown below.

Source: Credit Suisse

Whatever the case, the "run on banks" taking place in Spain a year ago seems to have stopped - for now. That in turn slightly reduced banks' reliance on the ECB, particularly in the short-term funding program (MRO).

And as discussed before (see post), this reversal of flows should reduce Spain's TARGET2 liability - which is exactly what happened.

Clearly, both of these measures are highly elevated relative to historical levels, but nevertheless the "bleeding" has been contained.

Wednesday, February 27, 2013

Recent retail numbers from France are showing an ongoing consumer recession in spite of signs of improvement in confidence elsewhere in the EU. In fact the EU economic sentiment numbers today beat expectations to the upside - nothing to write home about, but there are signs of stabilization (for now). French Retail PMI on the other hand shows highly stressed consumers generating the sharpest fall in retail sales in six months. French retail PMI materially dragged down the Eurozone's overall PMI.

Markit: - The French retail sector was caught in a deepening
downturn during February. Sales fell sharply on
both a monthly and annual basis, while there was a
survey-record shortfall versus previously set plans.
Retailers’ gross margins continued to be squeezed
by a combination of higher purchasing costs and strong competitive pressures.

France Retail PMI® (source: Markit)

Job losses in France are likely the culprit, as French jobless claims hit a 15-year high last month.

Reuters: - The number of people out of work in France shot up again in January after a smaller rise in December, piling new pressure on Socialist President Francois Hollande who has made tackling joblessness his top priority.

The number of jobseekers in mainland France jumped by 43,900 or 1.4 percent, signalling a return to the rapid pace of increase seen over 19 straight months to December - although half of the rise was due to a change in methodology in January.

Source: Deutsche Bank

Until job losses are under control, it is hard to imagine consumer sentiment and spending improving. And as we've seen in the US, the time period from job market improvements to pickup in consumer spending can be fairly long.

Tuesday, February 26, 2013

Questions continue to surround the Fed’s eventual exit from years of quantitative easing. The ultimate fate of what is to become of the 3.5 - 4 trillion dollar portfolio of securities (the expected peak holdings of Fed’s balance sheet) will determine, among other things, long-term interest rates, mortgage rates, corporate and US government borrowing costs, profitability of the banking system, returns on pension and insurance portfolios, and even the value of the dollar. In short, the exit strategy will drive the fixed income markets for years to come.

Some argue that the Fed has no need to sell securities and can simply sit on the portfolio as it winds down naturally through maturities and prepayments. The Fed can keep the economy from overheating by simply raising rates on excess reserves. And the fact that bank reserves (deposits at the Fed) will be in the trillions for years to come shouldn't matter they argue. That's because these reserves do not result in excessive lending and therefore are not inflationary. The lack of transmission from excess reserves to lending is visible in the so-called money multiplier (discussed here), which is at historical lows.

In normal times this argument may hold, but these are by no means normal times. By purchasing unprecedented amounts of securities, the Fed “created” trillions of excess reserves. And the central bank may not want to wait until 2020 (see post) for the reserves to decline to more normal levels on their own. Here are some reasons:

1. Some economists feel that even though reserves do not immediately transmit into lending, bank loans and leases have been rising steadily since early 2011 (QE2), and over the years could, if left unchecked, raise the money supply to inflationary levels.

Loans and leases on US banks' balance sheets (source: NY Fed)

2. Bloated excess reserves may ultimately impact the value of the dollar.

4. With the reserves at their expected peak the Fed would be paying out about $6bn per year in interest to banks on riskless deposits. And those of us who have checking and savings accounts know that the rate we get on deposits is close to zero. Corporate accounts are not much better. That means that the banking system will get to keep most of that money. Now if the Fed raises the rate it pays on reserves (as suggested above), the banks will generate multiples of that amount in riskless profits. Once again, in a normal environment that would not be a big deal, but these days the Fed doling out free money to banks is not going to be very popular with the public.

These are some of the reasons the Fed may choose to drain at least some of the reserves. Selling assets may be one way to do it, but that may shake up the markets and significantly raise long-term interest rates. It will also generate realized losses for the Fed – another potentially unpopular outcome. But there is another solution. Back in 2009 the Fed set up tri-party repo arrangements with a number of dealers (see 2009 post). Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves.

If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting.

Monday, February 25, 2013

All of a sudden Europe matters. As discussed last week (see post), Italy's election was creating risks of a "weak and fragmented coalition" that could slow down or even reverse the pace of much needed reforms. And now we are indeed looking at a deadlocked parliament, with little ability to form a coalition in the upper house.

Reuters: - A huge protest vote by Italians enraged by economic hardship and political corruption pushed the country towards deadlock after an election on Monday, with voting projections showing no coalition strong enough to form a government.

With more than two thirds of the vote counted, the projections suggested the center left could have a slim lead in the race for the lower house of parliament.

But no party or likely coalition appeared likely to be able to form a majority in the upper house or Senate, creating a deadlocked parliament - the opposite of the stable result that Italy desperately needs to tackle a deep recession, rising unemployment and a massive public debt.

Such an outcome has the potential to revive fears over the euro zone debt crisis, with prospects of a long period of uncertainty in the zone's third largest economy.

Of course people were quite surprised about the comeback of Berlusconi (discussed here back in December). It takes a crook to promise to pay the electorate for voting him in, but that's exactly what Berlusconi did. He tapped into the "electoral rebellion", and although he did not win, he certainly injected himself into whatever coalition that may end up being formed.

WSJ: - Surprising, too, was the comeback of Mr. Berlusconi, whose party was in the doldrums as late as November of last year. The 76-year-old billionaire politician's late surge is attributed largely to the media blitz in recent weeks.

"Whoever thought Berlusconi was finished will have to think again," said Angelino Alfano, head of the conservative People of Freedom party.
...
"The cost of austerity led to an electoral rebellion," said Enrico Letta, deputy head of the Democratic Party. "This is a complex situation to live and manage."

Italian government bond spreads widened in response and the euro sold off.

The market reaction was particularly strong in equities where Italian stocks took a real beating. The chart below shows market action over the past five days for EWI (USD-based Italian market ETF - blue) vs. SPY (S&P500 ETF - red).

Click to enlarge

Given that much of today's selloff took place after the European close, the markets' open in Europe tomorrow morning is expected to be ugly.

JPMorgan: - Leveraged loan funds had another record inflow, totaling +$1.42bn for the week
(2.90% of AUM), following previous record-high inflow totaling +$1.20bn the prior
week (2.52% of AUM). This marked the 35th consecutive inflow for loan funds, and
the breakdown of this week’s flows was a +$179mn inflow into the ETF (13%) and
an inflow totaling $1.24bn into actively managed funds (87%). For context, there
have only been two other $1bn+ weekly inflows reported for loans, with those being
December 22nd 2010 and February 9th 2011. Overall, the past four weeks’ inflows
are the largest for the asset class since 1Q11, a period when interest rate pressure
was elevated in the wake of QE2 and growth expectations were robust.

Indeed the demand for senior corporate loans of leveraged firms (otherwise known as "bank loans" because each is structured as a loan provided by a bank) is enticing companies to hit the market while the going is good. Loan issuance hit a new high recently.

Source: JPMorgan

The demand is not only coming from registered funds, but also from hedge funds as well as CLOs, (companies that securitize these loan portfolios). CLO volume clocked at $52 billion last year, while market participants expected only about $15 billion for 2012. The expectation for 2013 CLO issuance is $65bn according to JPMorgan, and all that collateral will have to come from somewhere.

As market participants rotate out of HY bonds, which have been frothy for some time (see post), and into loans, we are seeing the beginnings of another QE-driven market frenzy. Covenant-light transactions are a large part of the primary market recently,

JPMorgan: - ... the number of covenant-lite deals priced in the leveraged loan market
also remained heavy. Specifically, covenant-lite loans accounted for 41% of issuance
this week ($10.5bn), which followed $18.9bn (53%) last week, $14.7bn (47%) in
January, and $58bn (51%) in 4Q12.

... and deal leverage is increasing as well, with an average LBO at 5.5 times (according to S&P). This is still below the 6.2 record level reached in 2007, but in terms of the overall leverage we are roughly where deals priced during the 2005- 2006 period.

When the Fed looks for signs of liquidity-driven market pricing, the central bank won't need to look too far. The question is, are they looking at all?

Sunday, February 24, 2013

The recently released minutes of the last FOMC meeting made some economists and market participants begin contemplating the Fed's exit, its timing, and the implications. This is because the FOMC's discussion sounded a bit more hawkish than many had anticipated.

FOMC Minutes: - ... many participants
also expressed some concerns about potential costs and
risks arising from further asset purchases. Several participants
discussed the possible complications that additional
purchases could cause for the eventual withdrawal
of policy accommodation, a few mentioned the
prospect of inflationary risks, and some noted that further
asset purchases could foster market behavior that
could undermine financial stability.

But what will an exit from such extraordinary expansionary policy actually look like? Much of course will depend on the trajectory of the US economy in the next couple of years, but there are two key possibilities. One is that the Fed will simply end purchases and let the securities naturally pay down (due to prepayments on MBS) and mature. However, given the rate at which excess reserves are now being created through asset purchases, it may take too long to "drain" these balances (excess reserves represent the largest component of the monetary base now).

According to DB, without any securities sales it will take until 2020 before bank reserves return to normal - after the latest round of purchases as well as purchases yet to come. If inflationary pressures pick up, the pace of a "passive" exit may end up being insufficient.

The alternative would be to begin selling securities in order to accelerate the draining of the reserves. The chart below compares the two potential scenarios.

The liability side of Fed's balance sheet (source: Deutsche Bank)

But there is a cost to this "active" exit strategy. Long before the Fed officially telegraphs that it will begin selling, the markets will push long-term rates higher. MBS durations will extend as prepayments slow, and MBS spreads will likely widen. The market will begin effectively "front-running" the Fed. Moreover, MBS holders and mortgage servicers will begin to actively hedge their portfolios (something many are not doing now due to high prepayment activity) by shorting long-dated treasuries and steepening the yield curve more.

By the time the Fed actually begins selling, its massive securities holdings will likely be "under water" and many sales will result in realized losses (note that the Fed generally isn't concerned about unrealized losses that would be generated during a "passive" exit).

In recent years the net interest income generated by the Fed (less operating expenses) hit a record due to all the coupon payments in the Fed's portfolio. This income has been remitted to the US treasury on an annual basis. But as losses from sales accumulate, the "dividend" which the Fed has been paying in the past, will dwindle and possibly turn into a loss. The amount of loss will depend on interest rates as well as on the timing of the exit. According to DB, if sales begin this summer - an unlikely scenario - the net losses could largely be avoided.

Fed's net income under 3 scenarios (source: Deutsche Bank)

The blue line above dips further down of course if long-term rates move higher than projected. Some FOMC members are in fact becoming concerned about this outcome.

FOMC Minutes: - Several participants
noted that a very large portfolio of long-duration assets
would, under certain circumstances, expose the Federal
Reserve to significant capital losses when these holdings
were unwound...

Furthermore, if the Fed raises the overnight (Fed Funds) rate, it will also have to increase the rate it pays on excess reserves (the two will likely be adjusted in tandem), increasing the cost of liabilities and exacerbating losses. The "active" exit strategy therefore looks quite messy.

In practice however the Fed should be able to absorb such a loss. It would in effect "borrow" from itself to cover the loss until it generates enough income to extinguish this P&L item. This is "accounting magic" that only a central bank can implement.

DB: - Possibly in
anticipation of [losses], the Fed adopted new
accounting principles in January 2011, which specify that realizations of negative net income are capitalized as an
asset on their balance sheet. This “asset” would be
counterbalanced by the creation of additional reserves of
value equal to the asset. That is, the Fed would in essence
create new money to cover its losses. The increase in
reserves created to deal with the Fed’s income losses will
only partly offset the reduction in excess reserves
associated with the asset sales that generated the losses
in the first place.... Over time, the deferred asset would accumulate
if the Fed continued to experience negative net income
and be reduced when net income turned positive. Once
the deferred asset was reduced to zero again, the Fed
would resume remittance of its positive net income to the
Treasury.

Other than the loss of revenue for the US Treasury, the problem for the Fed will be mostly reputational, as it carries these losses on its balance sheet - potentially for years. But given the public's perception of the Fed these days, such a loss is something the FOMC will likely take quite seriously.

Homes available for sale as well as the housing supplies measured in months are now at pre-recession levels, while household formation continues to recover (see post). This development was predicted by William Wheaton back in 2009.

Source: JPMorgan

Forbes: - Most striking however is the fact that inventory has contracted to its lowest level since December 1999, more than 13 years ago. The number of available homes, which is not seasonally adjusted, fell 4.9% from December and is 25.3% lower than a year ago. With 1.74 million homes on the market, at the current sales pace, supply will be exhausted in just over four months. It represents the lowest housing supply since April 2005. In a normal market, a healthy supply level is about six months.

A number of economists continue to talk about the shadow inventory - the millions of homes that are "about to hit the market" as homeowners have or shortly will fail on their mortgages. Some evidence suggests that in the more depressed housing areas banks are indeed sitting on foreclosed properties, unwilling to sell. But a number of banks have also been aggressively modifying mortgages, reducing principal and interest, and therefore cutting delinquencies.

Clearly many more homes will be hitting the markets this year. But it really doesn't make much difference if people who move out of these homes end up buying or renting - they need to live somewhere. And according to the Census Bureau, rental vacancies are near a 10-year low.

Ironically, the relatively tight credit conditions are (at least partially) restricting new home construction. Completion of new housing units has improved recently but remains at historically depressed levels - certainly not enough to keep up with the population growth and family formation. The danger of course is that with spring approaching (generally a period of increased demand for homes), some markets could overheat due to tight supplies, worsening home affordability and dampening sales numbers.

Thursday, February 21, 2013

The Guardian had a good summary yesterday on the situation in Italy, where the recession is showing no signs of abating. The winner of the upcoming elections will face some severe challenges.

The Guardian: - A stagnating economy, corruption, organised crime, political apathy, misogyny, youth unemployment ... The person elected to run Italy next weekend will have a formidable to-do list.

The country is now in its longest recession in 20 years, the economy having contracted for the last six consecutive quarters and languished in more than a decade of almost non-existent growth. Unemployment is at more than 11%; for under-25s, it is more than 36%. Italy has the second highest ratio of sovereign debt to GDP in the EU.

It could have been worse. In autumn 2011, when Mario Monti took over after years of successive governments largely ignoring the problem, there were fears that the EU's fourth largest economy might fall into the abyss and drag the rest of the eurozone with it. The technocrat government avoided that disaster scenario and has done much to restore the markets' faith in Italy. Late last year, before the spectre of a Silvio Berlusconi comeback unsettled matters, 10-year bond yields were at a two-year low. It has implemented reforms – including of the pension system and labour market – that are viewed as a crucial part of long-term recovery and could, according to the IMF, lead to a 6% increase in GDP if properly implemented.

But economists say much more needs to be done to effect the kind of deep and lasting change needed to get Italy growing again. They focus on Italy's lack of competitiveness; its untapped labour market resources – women and young people; a thorough reform of product markets and of crucial institutions such as the justice and education systems. Only once these have been properly tackled, they say, will Italy be in a position to capitalise on its strengths, which include a strong manufacturing base, successful exporters, relatively low budget deficit and relatively high domestic savings. The big fear, however, is that the election will not usher in a strong, responsible government, but yet more political instability, which Italy can ill afford.

It is particularly troubling to see the industrial sector of the economy still contracting, even as Germany's industries stabilize.

Source: Deutsche Bank

As discussed earlier (see post), Berlusconi is now using the nation's economic mess to his advantage, increasing the risk to recent reforms implemented by Monti.

Reuters: - Confidence in Italy has been shaken in the run-up to the voting, after a strong campaign by former prime minister Silvio Berlusconi that has opened up the three-way race with outgoing premier Mario Monti and centre-left leader Pier Luigi Bersani.

"Investors are becoming more and more cautious ahead of the weekend ... and altogether people decided here to pull the trigger and go risk-off," said Christian Lenk, a fixed income strategist at DZ Bank.

According to S&P, Italy could repeat its history of forming "weak and fragmented coalition governments", dampening or even reversing the much needed reforms.

S&P: - We believe that a risk exists that after the Feb 24-25 elections there may be a loss of momentum on important reforms to improve Italian growth prospects ...

The implementation of measures to boost Italy's medium-term growth prospects depends, in our view, on the strength of the next government's mandate in both houses of parliament.

Wednesday, February 20, 2013

With March 1st approaching, the realization that sequestration may actually hit is setting in. Washington is nowhere close to a solution and the blame games are running rampant. The White House is now playing a "game of chicken" to see if the Republicans blink.

Politico: - With the parties at an impasse on stopping across-the-board budget cuts set to hit March 1, the White House is prepping another multimedia, cross-country drive to stoke public outrage against congressional Republicans.

Certain that the political winds are in their favor, they’re forgoing serious negotiations for a high-risk public offensive, banking almost entirely on the president’s ability to persuade. They believe that the GOP will be scared of taking the blame from an angry public — and the White House says this is just the kind of thing that gave them the victory they claimed in the fiscal cliff fight and the most recent standoff over the debt limit.

The markets are beginning to take notice. In spite of the overall US equity market having performed quite well recently, the defense sector, which is where half the cuts will be focused, is starting to underperform.

Source: Ycharts

Most expect the situation to be resolved right before or shortly after the deadline. But therein lies the "tail risk" - the possibility that this deadlock remains in place over a longer period with some material consequences for the US economy.

Barclays Research: - As has been the case over the past few years, negotiations could go down to the wire.
Unlike the past few negotiations, though, we think that the likelihood of the sequester
hitting on March 1 are fairly high. By late March, however, we suspect the across-the-board
cuts will end up being replaced with equivalent deficit cutting measures as part of the
continuing resolution (CR) negotiations. Nevertheless, with few economists expecting the
sequester to stick at all, the risks to ... markets in the event that gridlock sets in remain to
the downside...

Tuesday, February 19, 2013

France seems to be the only EMU nation who is undergoing a larger fiscal tightening in 2013 than it did in 2012.

Source: JPMorgan

While many of its austerity measures are clearly necessary, such action (combined with poor private sector competitiveness) is translating into a significant divergence in growth between France and the rest of the Eurozone. As discussed earlier (see post), the French composite PMI (manufacturing + services) has deviated sharply to the downside.

Source: JPMorgan

With this weakness in the corporate sector, it was not surprising to see Hollande announcing that France will miss its target on GDP growth this year.

Fox News: - French President Francois Hollande has said his country will miss its economic growth target this year.
Speaking during a brief visit to Athens on Tuesday, Hollande said that "everyone knows that for 2013, we will not reach our target, which was 0.8 percent."

There may be a lesson here for the US, which is quickly approaching the so-called "sequestration" (see discussion). An ill timed, sharp fiscal tightening could have a severe impact on a nation's economic growth.

According to the US Census Bureau, about 3.5 million households have been created over the past couple of years. As a comparison, only 755K were created in the previous two years (08-10) - with the recession hampering household formation. The following chart shows the ratio of the number of households (using the revised household number for 2011) to the US population over time. The ratio has stabilized, which is one of the reasons that demand for housing has improved recently.

Source: US Census Bureau

With pent up demand diminishing after 2013 however, housing price appreciation should revert back to the growth in household incomes (as discussed here). That means that going forward price increases on average should moderate.

It remains to be seen however if we are going to repeat an earlier pattern. The survey's historical data shows conditions peaking in late winter to early spring and declining later in the year.

Source: NY Fed

This pattern is not confined to NY state, and is in fact also visible at the national level. Within the next few days we should see the result from Markit US PMI for February, giving us a better feel for the trend in US manufacturing. So far however, the cycle remains intact.

But nowhere else is the cyclical pattern more visible than in the ISI's company survey (discussed here). In particular, the diffusion index is now once again pointing to expansion in the US corporate sector. But spring is fast approaching...

Sunday, February 17, 2013

As gasoline prices rise above $5/gallon in LA (see video below), analysts are puzzled. Gasoline prices have been on the rise for the past 31 days, which is highly unusual for this time of the year. Typically prices begin rising in March or April as the driving season kicks off.

The price increases are particularly puzzling, given the fact that US gasoline markets have been well supplied relative to historical levels.

Source: EIA

Certainly the recent increases in crude oil prices have been a large part of the explanation. Some have suggested that increased demand due to stronger global economic activity is to blame. Other reasons have been proposed as well.

CNN: - What's behind the higher prices at the pump? It's a confluence of factors, from rising crude oil prices, to production cuts and refinery closings.

Gasoline futures trading on NYMEX (CME) have been rising almost daily, pointing to even higher prices at the pump in the spring.

Source: CME

This is clearly going to create headwinds for consumer sentiment and ultimately spending patterns, particularly when combined with other issues consumers are facing this year.

CNN: - It's hitting wallets right in the middle of winter, when people are already looking at large home heating bills. And it comes just after many Americans have been hit with smaller paychecks, and are worried about looming budget cuts that could deliver an even deeper blow.

The growth in healthcare costs in the US has slowed substantially in recent years.

NY Times: - Since 2004 — nearly four years before the economic downturn — the rate of health care inflation per person has been just 0.8 percent higher than the growth of the G.D.P. Between 1965 and 1993, for comparison, it was 3.2 percent higher.

Some have argued that this stabilization is somehow benefiting the US consumer. It's not at all obvious this is the case however. What's really driving this slower growth in American healthcare costs? There seem to be two key factors at play:

1. Budgetary constraints are driving a reduction in Medicaid and ...

JPMorgan: - Medicaid is jointly
funded by federal and state governments, though the administration
of the program is carried out at the state level, including
decisions about the level of care and eligibility for the
program. Cash-strapped state governments have taken a variety
of measures to cut back on Medicaid spending, particularly
after a temporary bump up in the federal share of funding
expired in mid-2011. In fiscal year 2012 states undertook 193
separate actions aimed at containing Medicaid costs, such as
freezing or reducing provider payments or increasing copayments.
This fiscal year the states intend to take another 150
steps to limit Medicaid expenses.

... Medicare spending.

NY Times: - ... over the last 43 years, costs per beneficiary grew 2.7 percent faster than the overall economy. That’s why Medicare spending rose from $7.7 billion in 1970 (or 0.7 percent of gross domestic product) to $551 billion in 2012 (almost 4 percent of G.D.P.). But this trend has finally reversed; over the last three years, Medicare costs per person have grown 1.3 percent slower than growth in the overall economy. In January, a Department of Health and Human Services report showed that Medicare spending per beneficiary grew just 0.4 percent in 2012. And last week, the Congressional Budget Office lowered its 10-year Medicare spending projection by $137 billion.

2. In spite of improved trends in healthcare costs, health insurance premiums are still rising sharply.

NY Times: - Major insurers are proposing painful, double-digit premium increases in 2013. In California, Anthem Blue Cross, Blue Shield of California and Aetna all announced rate increases of 20 percent or higher for some of their customers.

... insurance companies are uncertain about the future, particularly about what will happen to their margins when the new exchanges open in October. The natural response to uncertainty is caution, and for insurance companies, the cautious approach is to increase revenue and profits as much as possible in the short term in case Obamacare lowers them in the long term.

These rising premiums have helped insurance companies' margins but have forced more strapped consumers to move into high-deductible plans, which are considerably cheaper.

Source: JP Morgan

Of course more people these days don't have any insurance at all or carry only hospitalization coverage. Having to pay for medical services out of pocket, except for the really large expenditures, is forcing consumers to spend less on care in general. Many simply don't seek care until they absolutely have to, which is reducing the overall demand for medical services (other than hospitalization - hospital admission rates seem to be at pre-recession levels). This weaker demand, driven by higher out-of-pocket requirements, helps contain general healthcare costs.

Consumers either pay higher premiums or higher deductibles, covering a larger portion of their care out of pocket. Similarly, medicaid recipients pay higher co-payments or face limited access to care. Clearly some of this is absolutely necessary in order to stabilize the out-of-control healthcare spending in the US (see discussion). But to argue that these trends are somehow helping consumers is simply flawed.

Saturday, February 16, 2013

In the past few weeks global markets have focused on the weakening yen, as politicians and business leaders, particularly in Europe have called for a halt in Japan's "weak currency" policy. Tokyo's efforts to stimulate it's export sector have become front and center topic in the financial media, as global businesses become increasingly concerned about the currency war. In fact the number of FT articles containing the word "yen" hit a record recently.

Number of FT articles containing “yen” (source: Merrill Lynch)

Similarly, Google search frequency for "JPY" rose recently as well.

Google Trends for "JPY"

Public's attention has therefore turned to the G20 meeting this week, where some have hoped Japan would be asked to moderate its policy. The Eurozone is particularly concerned that the relative strength of the euro will delay its exit from the economic malaise. Germany for example is in direct competition with Japan in auto sales, and a relatively small change in the EUR/JPY levels could result in major differences in sales and profit margins.

But with the world watching and the Germans hoping for action against Japan, the US quickly stepped in to support Japan's policy. After all the US has been following a similar policy itself. This NY Times article described the situation quite well:

NY Times: - Ben S. Bernanke, the Federal Reserve chairman, strongly indicated on Friday that the United States did not intend to censure Japan for weakening its currency over the last several months, something that has aided Japanese exporters and angered its competitors.

Mr. Bernanke spoke in brief introductory remarks at a conference in Moscow of the Group of 20, a club of the world’s largest industrial and emerging economies.

At issue are stimulus programs backed by Prime Minister Shinzo Abe, who is also maintaining pressure on the Bank of Japan to keep interest rates near zero and flood the economy with money to support Japanese manufacturers. As a result, the yen has lost about 15 percent of its value against the dollar over the last three months, meaning products made in Japan, like some Sony electronics or models of Toyota cars, are relatively cheaper.

Japan’s maneuver touched off fears that other countries and the European Union might follow suit in a so-called currency war, which has been the main topic of the Group of 20 meeting here, which runs through Saturday.

Initially, it seemed the world’s largest economies might agree on a firm statement at the end of the meeting to condemn a currency war, or competitive devaluations. This tactic is now widely seen as a beggar-thy-neighbor approach to creating growth that would ultimately harm a global recovery and is understood to be a cause of the lingering nature of the depression in the 1930s.

This is likely to drive a further wedge between the Fed's and the ECB's policy, while angering many politicians in Europe. Through his statements at the G20 meeting, Bernanke in effect just gave his nod to the continuation of the currency war.

Friday, February 15, 2013

When discussing the world of so-called "shadow banking" (see post), one should not forget the entities called Business Development Companies (BDCs). These are hybrids between investment and operating companies that can obtain up to 1:1 leverage on investors' capital in order to lend to (and sometimes invest in) mid-sized businesses in the US. The interest on the loans is used to pay periodic (for example quarterly) dividend. With demand for yield continuing to drive valuations, some public BDCs have done tremendously well. NYSE-listed Triangle Capital (TCAP) for example is up over 63% on a total return basis (capital appreciation plus dividends) over the past year (vs. under 16% for the S&P500). A number of other BDCs have also had a spectacular performance recently.

Source: Ycharts

But as the middle market loan spreads decline, BDCs' portfolio quality will decline as well. That's because in order to be able to pay the same dividend, these companies have to increase the risk profile of their portfolios. They are finding it harder these days to underwrite quality companies' debt at reasonable rates in this very competitive market - the pipeline of good deals is shrinking. Investors however just can't seem to get enough of these shares, as the Fed continues to pump liquidity into the market. At least in some instances, valuations already seem frothy - which may not end well, particularly when the flood of central bank stimulus stops (and possibly long before then).

Thursday, February 14, 2013

The strong jobless claims data released today certainly represents a positive trend for the US economy. Combined with the US housing market recovery (see story from CNBC), the data may be pointing to material improvements in the labor markets in the near future.

Bloomberg: - Claims for jobless benefits plunged last week, showing U.S. employers have little need to trim staff as demand improves.
Applications for unemployment insurance payments decreased by 27,000 to 341,000 in the week ended Feb. 9, fewer than any of the 49 economists surveyed by Bloomberg projected, according to Labor Department data issued today in Washington.

One should be careful however when extrapolating the path of US economic growth based on these numbers. First of all there is a great deal of noise associated with this data, especially on the seasonal adjustments.

Reuters: - But some economists said a blizzard that slammed the East Coast late last week and difficulties smoothing out the data for seasonal fluctuations could have artificially depressed claims.

While they were encouraged by the decline, they urged caution against reading too much into the data.

"Claims may not be giving a reliable signal about the labor market," said Daniel Silver, an economist at JPMorgan in New York.

It is particularly troubling to see some analysts draw a straight line through the seasonally adjusted initial jobless claims to determine how quickly the US labor markets may reach pre-recession levels. Stepping away from the seasonal adjustments, improvements in the claims number have been anything but linear. In fact a simple non-liner fit (from 2/7/09 to 2/9/13) shows a steady drop in the rate of declines.

There are other factors making this trend less reliable as a measure of the labor market strength, such as a large pool of workers who no longer qualify for these benefits. We are clearly moving in the right direction here, but it's important to interpret the results with some degree of caution.

Wednesday, February 13, 2013

The latest in the LIBOR scandal once again shined some light on RBS, the UK taxpayer-owned bank. The firm's culture that ultimately forced the UK government to execute one of the most expensive financial rescues in history was even worse than many imagined.

WSJ: - RBS's former head of investment banking, Johnny Cameron, who left the bank in early 2009, said traders at banks involved in the attempted rate manipulation had more in common with each other than other bank workers, and that their behavior seemingly had little to do with the firms they worked for.

It is "as much about the culture of traders and people who trade things than any bank," Mr. Cameron said in his testimony to the committee.

He said RBS's risk managers failed to recognize the potential for traders to influence submissions used to help set interest-rate benchmarks, and that the failure highlighted why traders need "tight and close management."

"I do think that traders have a particular approach to life and need much tighter controls. By and large, those controls are imposed. What happened in this case was that the risk managers didn't recognize this as a risk, and those controls were not there," Mr. Cameron said.

But RBS had a hefty risk management department back then, with some of the most sophisticated financial risk modelling in the industry and numerous risk analysts running around the firm "measuring" risk. The head of the market risk group (as well as quantitative analysis) at the time was Riccardo Rebonato (see bio on Wikipedia). So how is it that the exposures (particularly in mortgage portfolios at the subsidiary called Greenwich Capital) as well as trading practices at the firm were allowed to spin out of control under the watchful eye of Dr. Rebonato? It so happens that Dr. Rebonato did not seem to be too concerned with how to keep the bank from collapsing and instead was focused on writing his new (at the time) book called Plight of the Fortune Tellers. In fact the book was published while Dr. Rebonato was still at RBS (in 2009).

So "who cares?", one may ask. If Dr. Rebonato has done such a stellar job at RBS during the housing bubble, one should be asking "where is he now?" It turns out that he has a new role, this time at PIMCO. And it is likely that he is working on his new book - to be released after the next financial correction. This and similar hires at the large fixed income asset managers (such as Blackrock, who is actively hiring quants in the risk management area) may be pointing to the next financial bubble (see discussion).

As the so-called sequestration approaches, jitters among defense contractors are becoming quite visible. 50% of the cuts are expected to hit the Pentagon budget. States like Virginia, where the defense industry is a major portion of private employment as well as a key source of tax revenue, are also becoming uneasy.

Source: ABC News

The markets however seem to be shrugging off the impact of sequestration. Over the past few months (including the post-election period) a basket of major defense stocks has performed in line with the S&P500. And in spite of sequestration's overall negative impact on the GDP, the broad market is near multi-year highs.

Source: Ycharts

Market expectations seem to indicate that these cuts will be avoided - possibly at the last minute. For now however it looks as if sequestration may potentially go into effect.

Bloomberg: - Democrats and Republicans in the U.S. Congress are nowhere near a plan to avert $1.2 trillion in spending cuts about two weeks before they are set to begin.

It’s the latest in a series of fiscal deadlines created by Congress that in the past two years took the U.S. to the brink of a debt default, a government shutdown and middle-class tax increases that neither party wanted. Unless lawmakers act, the across-the-board spending reductions will begin March 1.

Leaving the cuts in place would shave U.S. economic growth this year by 0.6 percent and cost 750,000 jobs by the fourth quarter, Congressional Budget Office Director Doug Elmendorf said yesterday at a hearing.

About half the cuts would affect defense spending, and military leaders are pressuring lawmakers to avoid them. Allowing the reductions, known as sequestration, to take effect would mean less training for Army personnel and fewer purchases of Navy vessels and Air Force fighter jets, the leaders said.

“It’s pretty clear to me that the sequester’s going to go into effect,” Senate Minority Leader Mitch McConnell, a Kentucky Republican, said yesterday.

And it seems that a number of politicians actually want to see sequestration activated.

Tuesday, February 12, 2013

After this post in early December discussing the possibility that MBS, particularly the 30yr FNMA had become a "crowded trade", we've received numerous e-mails arguing that based on the Fed's recent actions, agency MBS has more upside. Furthermore, the US consumer got so used to mortgage rates constantly moving lower, the reversal (discussed in that post) of that trend seemed unfathomable to many. But that is in fact what happened as the 30yr mortgage rate stopped declining.

Source: Bankrate.com

This reversal in mortgage rates was in fact driven by the sell-off in long-dated agency MBS, which many argued would not happen this quickly - yet here we are.

Source: Mortgage News Daily

There are a number of reasons for the sell-off and the recent (mild) rise in the 30y conventional mortgage rates:

1. Dealers have built up a massive inventory of this paper, making it a bit more vulnerable to a correction.

2. Treasuries have sold off materially since early December (about 35bp yield increase on the 10y note), dragging MBS with them.

3. Some institutional investors are preparing for the Fed's eventual exit by unwinding their MBS holdings.

Reuters: - The PIMCO Total Return Fund, the world's largest bond fund run by Bill Gross, decreased its mortgage holdings to its lowest level since mid-2011, ahead of the prospect of higher interest rates and emerging inflationary pressures.

4. The Fed's purchases have been increasingly focused away from the 30yr FNMA, which they probably view as overpriced, and more on the GNMA and the shorter maturity FNMA (such as 15yr) bonds.

Source: JPMorgan ("Conv." stands for "conventional")

That's one of the reasons the 15yr mortgage rate has not moved up as much as the conventional 30yr.

Going forward, the direction of agency MBS paper is less clear, particularly given the tremendous dependence on the Fed who will be growing its balance sheet to unprecedented levels. The upcoming US sequestration cuts could in fact push treasuries higher (by slowing economic growth), with MBS following. On the other hand institutions will certainly become more cautious on their MBS holdings, given the increased rate risk.

Sunday, February 10, 2013

The Egyptian pound continues to weaken, as the central bank attempts to stem the run on the currency by imposing among other measures a tight trading range. Anecdotal evidence suggests that a number of wealthy individuals and businesses are quietly converting savings into hard currency and to the extent possible depositing funds abroad. Some are buying gold as inflation accelerates (see BW story).

Source: Investing.com

Any time currency controls are imposed, a black market usually develops. And Egypt is no exception.

Fox Business: - A run on Egypt's pound has left foreign currency in short supply and driven some dealers into the streets in search of people with U.S. dollars to sell, spawning a new black market.
...
"There are no dollars. Everyone that walks in asks for dollars but supply is scarce," said one of the dealers.

The central bank took steps last week to manage the rate including narrowing the pound's trading band. It was last bid at 6.71 [actually it's 6.73 now] to the dollar on Sunday in interbank trade.
...
The pound's decline has been reflected in a drop in Egypt's foreign reserves, which fell to $13.6 billion at the end of January - below the $15 billion level needed to cover three months' imports. The reserves stood at $36 billion on the eve of the uprising against Mubarak.

Complicating a business climate already weighed down by political unrest, some importers say they are having to source their foreign exchange needs from what they call the parallel or open market.

One senior executive at an Egyptian company that imports goods from abroad said companies were able to source their dollar needs from the black market, but forecast that supply would tighten further in the coming weeks.

Egypt desperately needs the IMF loan that was arranged last year but is yet to be disbursed. However the IMF wants to make sure that political stability is reached and the government implements the measures it had promised, such as certain tax increases. In the mean time - in a classic "chicken-or-the-egg" situation - foreign reserves continue to dwindle.

We all talk about the old RO-RO - the so called "risk-on/risk off" behavior of markets. It hasn't always been this way. "Risk assets" became particularly correlated after the financial crisis (see 2009 discussion). Many newer market participants simply accept this as a given. One constantly hears comments such as "it's been a risk-off week". It's as though there are just two markets in the world: one consisting of the euro, the S&P500, oil, etc. and the other of treasuries and the US dollar.

Recently, however, correlations among risk assets have been on a decline. Certainly they are still elevated, as macro-focused asset managers reallocate exposures far more efficiently than they did 10 years ago. But market participants are beginning to differentiate among risk assets.

The Australian dollar is a good example. Generally viewed as one of the "risk assets" due to the nation's exposure to natural resources and therefore global growth, AUD has correlated well with other such assets. When we discussed the fact the AUD remains vulnerable due to Australia's economic slowdown (see discussion), many FX traders remained skeptical. The view was that the "risk-on" trade will lift AUD irrespective of Aussie growth. That's not what happened however, as we've seen AUD decouple strongly from risk assets such as equities.

Similarly, the Japanese yen recently lost its status as a "risk-off" trade due to Japan's fundamentals (see discussion). So before jumping on the next RO-RO bandwagon, consider the fact that these days not all risk-on (as well as "risk-off") assets are "created equal".

Saturday, February 9, 2013

Some folks in the media are making a big deal out of the US trade deficit decline in December.

The SF Chronicle: - Number of the day: 20.7 percent
That's how much the U.S. trade deficit shrank in December from the previous month, the U.S. Commerce Department said Friday. The gap between imports and exports was the smallest since January 2010 and much less than the $46 billion expected by 73 economists in a Bloomberg poll. The deficit was cut by record exports of refined petroleum products to countries such as Brazil, combined with lower imports of crude oil.

Yes, that's an impressive showing indeed. But let's take a look at the chart, because such numbers should not be viewed in isolation. The decline in deficit follows a sharp increase a month earlier.

The deficit increase in November was driven by hurricane Sandy, and was exacerbated by the Northeast US refineries' shutdowns. Fuel output in November dropped materially. The lower imports in December are therefore distorted by the reversal of the "Sandy effect". Trade deficit excluding fuel in fact declined less sharply than the overall number in December.

This is clearly a welcome result, but the real trend will not be fully visible until the January numbers are out.

Brazilian central bank's highly accommodate policy in the past year and the recent weakness in the Brazilian real has helped boost growth.

But with economic growth stabilizing, the nation is beginning to face inflationary pressures (as predicted). Ultra dovish central bank policies, whether in Brazil or elsewhere, usually come at a price.

Reuters: - Brazil's inflation accelerated
to the fastest rate in nearly eight years in January, raising
bets of an interest rate hike this year that could complicate
the government's drive to reignite a near-stagnant economy.

The Brazilian currency, the real , also jumped
on the news, hitting a 9-month high against the dollar after
central bank president Alexandre Tombini said he was worried
about inflation.

Brazil's inflationary pressures are becoming broad-based instead of simply focused on a particular sector of the economy.

GS: - What is of particular concern is that the acceleration of inflation in Brazil was broad-based, i.e., it was not driven by narrow-based shocks to just a few items. In fact, the Brazil IGI shows that items with a combined weight of about 60% in the CPI have annualized seasonally adjusted inflation now running above the 6.5% inflation target upper limit.

In response, the central bank is expected to begin raising rates aggressively - with futures already pointing to 100bp increase in the near future, - dampening the nascent economic recovery.

It's quite amazing how the world has changed in just a few months. Back in July traders were still piling into the short-euro trade. Nobody wanted to hear that it was becoming a "crowded trade" (as discussed here) - after all the euro "can only go down". Since then these euro bears have endured pain, as the sentiment reversed sharply. The Goldman EUR/USD sentiment index, which is based on the CFTC statistics of speculative positions of futures traders, is moving deep into the bullish territory.

GS: - Net EUR long spec positioning continued to rise; at 80.4 percent our Sentiment Index (SI) is now at its highest level since May 2011

The fundamentals continue to support this position, with the ECB uninterested in pushing the euro lower (see post). But the technicals will need to be watched closely for signs of overcrowding.